Chapter Notes

Meaning of Debentures

While companies raise capital by issuing shares, this is often not enough to cover their long-term financial needs. To secure more long-term funds, companies often turn to borrowing through debentures. This is essentially a form of long-term debt.

A debenture is a formal, written document issued by a company that acknowledges a debt. The word itself comes from the Latin word 'debere,' which means "to borrow." This document, sealed by the company, is a contract that promises to repay the principal amount after a certain period and to pay interest at a fixed rate, usually semi-annually or annually.

According to Section 2(30) of The Companies Act, 2013, the term 'Debenture' covers a wide range of securities, including debenture inventory and bonds, regardless of whether they are secured by the company's assets.

A bond is also an instrument acknowledging debt. While traditionally issued by governments, today they are also issued by semi-government and non-governmental organizations. In modern finance, the terms 'debenture' and 'bond' are often used interchangeably.

Distinction between Shares and Debentures

It's crucial to understand how debentures differ from shares, as they represent two fundamentally different ways of financing a company.

• Ownership: A share represents a piece of ownership in the company (owned capital), making the shareholder a part-owner. A debenture, on the other hand, is simply an acknowledgment of a loan (borrowed capital), making the debenture holder a lender to the company.
• Return: The return on shares is called a dividend, which is a share of the company's profits. Its rate can change each year. The return on debentures is interest, which is paid at a pre-fixed rate.
• Nature of Payment: Paying dividends is an appropriation of profits—it's only done if the company makes a profit. Paying interest is a charge on profits, meaning it must be paid even if the company incurs a loss.
• Repayment: Share capital is generally not returned to shareholders during the company's lifetime. Debentures are typically issued for a specific period and are repaid upon maturity.
• Voting Rights: Shareholders, as owners, have voting rights in the company's decisions. Debenture holders, as lenders, do not have voting rights.
• Security: Shares are unsecured. Debentures are usually secured by a charge on the company's assets. This means if the company fails to pay, the assets can be sold to repay the debenture holders.
• Convertibility: Shares cannot be converted into debentures. However, debentures can be converted into shares if the terms of issue allow for it; these are known as convertible debentures.

Types of Debentures

Debentures can be classified based on different criteria:

From the Point of view of Security

• Secured Debentures: These debentures are backed by a charge on the company's assets. If the company defaults on payment, these assets can be sold to repay the debenture holders. The charge can be a fixed charge (on a specific asset, like a building) or a floating charge (on the general assets of the company).
• Unsecured Debentures: These have no specific charge on the company's assets. These are not commonly issued.

From the Point of view of Tenure

• Redeemable Debentures: These are issued for a fixed period and are repaid (redeemed) at the end of that period, either in a single lump sum or in installments.
• Irredeemable Debentures (Perpetual Debentures): The company does not promise to repay the principal amount during its lifetime. These are typically repaid only when the company is winding up.

From the Point of view of Convertibility

• Convertible Debentures: These can be converted into equity shares or other securities after a specific period, either at the option of the company or the debenture holder. They can be fully or partly convertible.
• Non-Convertible Debentures: These cannot be converted into shares. Most debentures fall into this category.

From Coupon Rate Point of view

• Specific Coupon Rate Debentures: These carry a specified interest rate, known as the coupon rate. The rate can be fixed or floating (often linked to the bank rate).
• Zero Coupon Rate Debentures: These do not have a specified interest rate. To compensate investors, they are issued at a significant discount. The difference between the issue price and the face value represents the total interest for the duration of the debenture.

From the view Point of Registration

• Registered Debentures: The company maintains a register with the names, addresses, and holding details of all debenture holders. These can only be transferred through a formal transfer deed.
• Bearer Debentures: These are transferable by mere delivery, like currency notes. The company does not keep a record of the holders. Interest is paid to whoever presents the interest coupons attached to the debenture certificate.

Issue of Debentures

The process for issuing debentures is similar to that of issuing shares. A company issues a prospectus, and interested investors apply. The company can collect the full amount on application or in installments (application, allotment, and calls).

Debentures can be issued in three ways:

1. At Par: The issue price is equal to the face value.
2. At a Premium: The issue price is more than the face value.
3. At a Discount: The issue price is less than the face value.

Issue of Debentures for Cash

Issue at Par

When a debenture's issue price is the same as its face value (e.g., a ₹100 debenture issued for ₹100), it is issued at par.

Journal Entries (if the amount is received in installments):

1. On receipt of application money: Bank A/c Dr. To Debenture Application A/c

2. On allotment of debentures (transferring application money): Debenture Application A/c Dr. To Debentures A/c

3. For allotment money due: Debenture Allotment A/c Dr. To Debentures A/c

4. On receipt of allotment money: Bank A/c Dr. To Debenture Allotment A/c

Journal Entries in the books of ABC Ltd.:

1. For application money received (9,000 debentures x ₹30): Bank A/c Dr. 2,70,000 To 12% Debenture Application A/c 2,70,000

2. For transfer of application money to Debentures A/c: 12% Debenture Application A/c Dr. 2,70,000 To 12% Debentures A/c 2,70,000

3. For allotment money due (9,000 debentures x ₹70): 12% Debenture Allotment A/c Dr. 6,30,000 To 12% Debentures A/c 6,30,000

4. For receipt of allotment money: Bank A/c Dr. 6,30,000 To 12% Debenture Allotment A/c 6,30,000

Issue at a Discount

When a debenture is issued for less than its face value (e.g., a ₹100 debenture issued for ₹95), the ₹5 difference is the discount. Unlike shares, there are no restrictions under the Companies Act, 2013 on issuing debentures at a discount. This discount is a capital loss and is written off during the life of the debentures, usually against the Securities Premium Reserve or the Statement of Profit and Loss.

Journal Entry for allotment money due (when discount is adjusted at allotment): Debenture Allotment A/c Dr. (Amount received) Discount on Issue of Debentures A/c Dr. (Discount amount) To Debentures A/c (Face value)

Journal Entries:

1. For application money received (10,000 debentures x ₹40): Bank A/c Dr. 4,00,000 To 12% Debenture Application A/c 4,00,000

2. For transfer of application money: 12% Debenture Application A/c Dr. 4,00,000 To 12% Debenture A/c 4,00,000

3. For allotment money due (including discount):

   • Total face value due on allotment = ₹60 (₹100 - ₹40)
   • Discount = 5% of ₹100 = ₹5
   • Cash to be received = ₹60 - ₹5 = ₹55
   • Journal Entry: 12% Debenture Allotment A/c Dr. 5,50,000 (10,000 x ₹55) Discount on Issue of Debentures A/c Dr. 50,000 (10,000 x ₹5) To 12% Debenture A/c 6,00,000 (10,000 x ₹60)

4. For receipt of allotment money: Bank A/c Dr. 5,50,000 To 12% Debenture Allotment A/c 5,50,000

Issue at a Premium

When a debenture is issued for more than its face value (e.g., a ₹100 debenture for ₹110), the extra ₹10 is the premium. This amount is credited to a separate account called Securities Premium Reserve and is shown under "Reserves and Surpluses" on the liabilities side of the Balance Sheet.

Journal Entry for allotment money due (when premium is collected at allotment): Debenture Allotment A/c Dr. (Total amount due) To Debentures A/c (Face value) To Securities Premium Reserve A/c (Premium amount)

Journal Entries:

1. For application money received (2,000 debentures x ₹50): Bank A/c Dr. 1,00,000 To 10% Debenture Application A/c 1,00,000

2. For transfer of application money: 10% Debenture Application A/c Dr. 1,00,000 To 10% Debentures A/c 1,00,000

3. For allotment money due (including premium):

   • Total due on allotment = ₹60
   • Face value part = ₹50 (₹100 - ₹50)
   • Premium = ₹10
   • Journal Entry: 10% Debenture Allotment A/c Dr. 1,20,000 (2,000 x ₹60) To 10% Debentures A/c 1,00,000 (2,000 x ₹50) To Securities Premium Reserve A/c 20,000 (2,000 x ₹10)

4. For receipt of allotment money: Bank A/c Dr. 1,20,000 To 10% Debenture Allotment A/c 1,20,000

Over Subscription

When a company receives applications for more debentures than it offered, it is called over subscription. The company cannot allot more debentures than it issued. The excess application money is handled as follows:

• Money from completely rejected applications is refunded.
• Excess money from partially allotted applications (pro-rata allotment) is adjusted against the amount due on allotment and subsequent calls.

Issue of Debentures for Consideration other than Cash

Sometimes, a company buys assets or an entire business and pays the seller (vendor) by issuing debentures instead of cash. The debentures can be issued at par, premium, or discount.

Journal Entries:

1. On purchase of assets: Sundry Assets A/c Dr. To Vendor's A/c

2. On issue of debentures to the vendor:

   • At Par: Vendor's A/c Dr. To Debentures A/c
   • At a Premium: Vendor's A/c Dr. To Debentures A/c To Securities Premium Reserve A/c
   • At a Discount: Vendor's A/c Dr. Discount on Issue of Debentures A/c Dr. To Debentures A/c

• Case 1: Issued at Par Number of debentures = ₹1,98,000 / ₹100 = 1,980 debentures. Journal Entry: Suppliers Ltd. A/c Dr. 1,98,000 To 12% Debentures A/c 1,98,000

• Case 2: Issued at 10% Discount Issue price = ₹100 - ₹10 = ₹90. Number of debentures = ₹1,98,000 / ₹90 = 2,200 debentures. Journal Entry: Suppliers Ltd. A/c Dr. 1,98,000 Discount on Issue of Debentures A/c Dr. 22,000 (2,200 x ₹10) To 12% Debentures A/c 2,20,000 (2,200 x ₹100)

• Case 3: Issued at 10% Premium Issue price = ₹100 + ₹10 = ₹110. Number of debentures = ₹1,98,000 / ₹110 = 1,800 debentures. Journal Entry: Suppliers Ltd. A/c Dr. 1,98,000 To 12% Debentures A/c 1,80,000 (1,800 x ₹100) To Securities Premium Reserve A/c 18,000 (1,800 x ₹10)

Purchase of a Business

When a company acquires a business, it takes over both assets and liabilities. The purchase consideration is the price paid for the net assets (Assets - Liabilities).

• If the purchase consideration is more than the net assets, the difference is debited to the Goodwill A/c.
• If the purchase consideration is less than the net assets, the difference is credited to the Capital Reserve A/c.

Issue of Debentures as a Collateral Security

When a company takes a loan from a bank, it provides a primary security (like land or buildings). Sometimes, the bank may ask for additional or secondary security. In such cases, the company may issue its own debentures to the lender. This is known as issuing debentures as collateral security.

These debentures do not create an immediate liability. They only become active if the company defaults on the loan repayment. There are two methods to account for this:

• First Method (No Journal Entry): No entry is passed in the books. A note is simply added below the bank loan in the Balance Sheet stating that the loan is secured by the issue of debentures as collateral security.
• Second Method (Journal Entry Passed): A journal entry is recorded to reflect the issue.
  • On issuing debentures as collateral: Debenture Suspense A/c Dr. To Debentures A/c
  • In the Balance Sheet, the 'Debenture Suspense A/c' is shown as a deduction from the 'Debentures A/c' under Long-term Borrowings, resulting in a nil effect. When the loan is repaid, this entry is reversed.

Terms of Issue of Debentures

The terms of issue also specify the conditions for redemption (repayment). Redemption means discharging the debenture liability. This can be done at par or at a premium. This gives rise to six common scenarios for issuing debentures.

Here are the journal entries for the six scenarios at the time of issue:

1. Issued at Par, Redeemable at Par: (Standard entries as discussed before) Bank A/c Dr. To Debenture Application & Allotment A/c Debenture Application & Allotment A/c Dr. To Debentures A/c

2. Issued at a Discount, Redeemable at Par: Bank A/c Dr. To Debenture Application & Allotment A/c Debenture Application & Allotment A/c Dr. Discount on Issue of Debentures A/c Dr. To Debentures A/c

3. Issued at a Premium, Redeemable at Par: Bank A/c Dr. To Debenture Application & Allotment A/c Debenture Application & Allotment A/c Dr. To Debentures A/c To Securities Premium Reserve A/c

4. Issued at Par, Redeemable at a Premium: Bank A/c Dr. To Debenture Application & Allotment A/c Debenture Application & Allotment A/c Dr. Loss on Issue of Debentures A/c Dr. (with redemption premium) To Debentures A/c To Premium on Redemption of Debentures A/c

5. Issued at a Discount, Redeemable at a Premium: The 'Loss on Issue of Debentures A/c' will include both the issue discount and the redemption premium. Bank A/c Dr. To Debenture Application & Allotment A/c Debenture Application & Allotment A/c Dr. Loss on Issue of Debentures A/c Dr. (discount + premium) To Debentures A/c To Premium on Redemption of Debentures A/c

6. Issued at a Premium, Redeemable at a Premium: Bank A/c Dr. To Debenture Application & Allotment A/c Debenture Application & Allotment A/c Dr. Loss on Issue of Debentures A/c Dr. (with redemption premium) To Debentures A/c To Securities Premium Reserve A/c (with issue premium) To Premium on Redemption of Debentures A/c

Interest on Debentures

A company is legally obligated to pay interest on its debentures at a fixed rate, regardless of whether it makes a profit. This interest is a charge against profit.

As per the Income Tax Act, 1961, the company must deduct Tax Deducted at Source (TDS) at the prescribed rate before paying interest to the debenture holders and deposit it with the government.

Accounting Treatment for Interest

1. When interest is due: Debenture Interest A/c Dr. (Gross interest) To Debentureholders A/c (Net interest payable) To Income Tax Payable A/c (TDS amount)

2. For payment of interest to debenture holders: Debentureholders A/c Dr. To Bank A/c

3. For payment of TDS to the government: Income Tax Payable A/c Dr. To Bank A/c

4. At the end of the year, for transferring interest to P&L: Statement of Profit and Loss Dr. To Debenture Interest A/c

Writing off Discount/Loss on Issue of Debentures

The Discount or Loss on Issue of Debentures is a capital loss. It should be written off in the year the debentures are issued. The preferred source for writing it off is the Securities Premium Reserve. If the reserve is insufficient, the balance is written off against the Statement of Profit and Loss.

Journal Entry for writing off: Securities Premium Reserve A/c Dr. (to the extent available) Statement of Profit and Loss Dr. (for the remaining balance) To Discount/Loss on Issue of Debentures A/c

Redemption of Debentures

Redemption of debentures refers to the repayment of the debenture amount to the holders, thereby extinguishing the liability.

Methods of Redemption

There are four main ways to redeem debentures:

1. Payment in Lump Sum: The entire amount is paid to all debenture holders at the maturity date.
2. Payment in Instalments: A portion of the debentures is redeemed each year, usually selected by a draw of lots.
3. Purchase in the Open Market: The company buys its own debentures from the stock market and cancels them. This is advantageous if the debentures are trading at a discount.
4. By Conversion into Shares or New Debentures: Holders of convertible debentures are given the option to convert their holdings into new shares or debentures.

Sources and Legal Requirements for Redemption

A company must consider legal requirements for redemption, primarily related to creating reserves.

• Debenture Redemption Reserve (DRR): For "other unlisted companies," it is mandatory to create a DRR equivalent to 10% of the value of outstanding debentures. This reserve is created out of profits available for dividends. Certain entities like All India Financial Institutions, banking companies, and listed companies are exempt from creating a DRR.
• Debenture Redemption Investment (DRI): All companies required to create DRR must invest or deposit a sum equal to at least 15% of the amount of debentures maturing during the year. This investment must be made on or before April 30 of that year in specified securities.

Redemption by Payment in Lump Sum

When debentures are paid off in a single transaction at maturity.

Journal Entries at Redemption:

• If redeemed at par: Debentures A/c Dr. To Debentureholders A/c Debentureholders A/c Dr. To Bank A/c

• If redeemed at premium: Debentures A/c Dr. Premium on Redemption of Debentures A/c Dr. To Debentureholders A/c Debentureholders A/c Dr. To Bank A/c

Redemption by Payment in Instalments

The accounting entries are the same as for lump-sum redemption, but they are passed each year only for the portion of debentures being redeemed in that year.

Redemption by Purchase in Open Market

When a company buys its own debentures from the market for immediate cancellation.

• If the purchase price is less than the face value, the difference is a profit, which is transferred to Capital Reserve. Journal Entry: Debentures A/c Dr. (Face Value) To Bank A/c (Purchase Price) To Profit on Redemption of Debentures A/c (Profit)

• If the purchase price is more than the face value, the difference is a loss, which is written off from the Statement of Profit and Loss.

Redemption by Conversion

When debenture holders convert their debentures into new shares or debentures.

• Amount due to debenture holders = 1,000 x ₹100 = ₹1,00,000.
• Issue price per equity share = ₹10 (face value) + ₹2.50 (premium) = ₹12.50.
• Number of shares to be issued = ₹1,00,000 / ₹12.50 = 8,000 shares.

Journal Entries:

1. To make the amount due to debenture holders: 15% Debentures A/c Dr. 1,00,000 To Debentureholders A/c 1,00,000

2. To issue shares in settlement: Debentureholders A/c Dr. 1,00,000 To Equity Share Capital A/c 80,000 (8,000 shares x ₹10) To Securities Premium Reserve A/c 20,000 (8,000 shares x ₹2.50)